Emerging markets become less attractive as commodity prices fall

Emerging markets become less attractive as commodity prices fall

11-08-2015 | Insight

Emerging markets are becoming less attractive as falling commodity prices and fears over Chinese growth pose a threat to equity values, says Robeco’s head of asset allocation.

  • Lukas Daalder
    Former CIO Robeco Investment Solutions. Daalder left Robeco in July 2018.

Speed read

  • Emerging market equities resume underperformance in Q2
  • Falling commodity prices hurt economies reliant on them
  • Fears of a Chinese growth slowdown also hurts sentiment
  • Developed market equities with more reliable growth preferred

Developed world equities show more promise and are preferred over underperforming emerging market stocks, says Lukas Daalder, Chief Investment Officer of Robeco Investment Solutions.

“After moving in a broad trading range for most part of 2014, emerging markets have resumed their underperformance in the second quarter of this year,” he says. “This partly reflects the wide swings of the Chinese markets, but also a more fundamental deterioration. Weak commodity prices, uncertainty over the strength of the Chinese economy, the upcoming Fed rate hike and the expected strengthening of the dollar related to that: the general picture is not very promising.”

He says some equities in emerging markets have become relatively cheap, but prices can be volatile, and may not reflect underlying fundamentals. “The one factor that is in favor of emerging markets is the valuation part, but as we have often stated, that is not a very reliable timing mechanism. All in all, in the second half of July, we decided to go underweight on emerging markets in favor of developing markets.”

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Slowdown across the board

Daalder says continuing falls in commodity prices, including another sharp drop in the price of oil last month, does not bode well for economies that depend heavily on natural resource income. China is the chief culprit as usual on lowered demand, but a wider slowdown in emerging markets is more to blame, he says.

“Although it does not appear that overall world demand is the main cause behind the commodity sell-off, there is another option as well: the composition of growth,” he says. “The world economy is still trotting along fine, with the US and Europe producing decent growth figures, but this is far less so the case with respect to emerging markets.”

“With the exception of the Eastern European countries and India, all of the major economies have been slowing down, with the overall manufacturing PMI for emerging markets now at 49.1, below the neutral level of 50. Countries like Brazil and Russia have reported negative growth on a GDP level, with limited hope of a quick turnaround.”

Figure 1 The PMIs of leading emerging markets. Figures below 50 indicate a slowdown. Source: Bloomberg, Robeco

Twofold link with commodities

The reliance of emerging markets on commodities, and the role that China plays as the world’s leading buyer of raw materials, makes it hard to be more optimistic, Daalder says.

“The link between commodities and emerging markets is twofold. On the one hand, emerging markets are major suppliers of commodities, with a big part of their exports linked to the commodity trade. Lower commodity prices will therefore have a negative impact on growth, which is indeed one of the reasons behind the weakness seen in various parts of the world.”

“On the other hand, over the last decade, emerging markets have been the net buyers of commodities, with China being the big elephant in the room. A slowdown in the Chinese economy would therefore have a bigger net impact on the end-demand for certain commodities, than a slowdown of the US economy. In other words, is the collapse of the commodity prices not also a symptom of a slowdown of the Chinese economy?”

Figure 2 The link between commodity values and emerging market share prices. Source: the Economist.

Just how bad is China’s slowdown?

Daalder says this is the million dollar question that keeps being asked: just how bad is the Chinese slowdown? “This brings us to the murky business of looking at Chinese statistics,” he says. “Officially, there are no problems; nothing to worry about. GDP expanded by a healthy 7% in the second quarter, neatly in line with the growth forecast the Chinese authorities aim for, for the year as a whole.”

“But looking at alternative measures like freight traffic or electricity production, the picture is a whole lot less convincing. Circumstantial evidence like continued weak world trade data, lackluster industrial production in the Asian region as a whole and the recent turmoil in the Chinese stock markets also seems to be pointing in the direction of weaker, rather than stronger growth.”

“As always, it is difficult to reach any definite conclusion on the Chinese economy, but based on what we see, we are more cautious than normal. Having said that, central authorities are never to be underestimated, meaning that if growth slows down too much, new stimulus measures are to be expected.”

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